ETFs: What They Are, What They Are Not

The investment industry seems to come up with a world-changing investment idea every four or five years. The hype can be numbing, but there’s one trend on which you should get educated — exchange-traded funds, often referred to by the acronym ETFs.

At the end of 2011, ETFs controlled $992 billion in assets, less than a tenth of the money in mutual funds. But that’s up from zero in 1993, when the first ETF was launched to track the Standard & Poor’s 500 index of stocks.

Originally designed to give investors a cheap way to mimic the broad market, today there are more than 1,400 such funds covering some fairly exotic, high-risk niches, such as single-country ETFs and funds designed to profit from short-term commodity price movements.

Why so much growth, so fast? Well, ETFs are cheap. A mutual fund by its design offers you access to money managers you might not otherwise be able to afford. But access to their brainpower costs you in fees which, over time, sap your return.

An ETF by design is on autopilot, owning just the stocks or other assets in its niche, say, the S&P 500 or a selection of highly rated corporate bonds. Keeping it simple drives costs down — the money you pay goes to an asset, not some hero fund manager with a God complex. The presumption is that you intend to hold that asset class for a specific period of time as part of a broader strategy. ETFs keep your plan cheap and more money on your side of the ledger. Pretty good stuff.

But, it’s important to understand the limits of this strategy, attractive it might be at first blush. Here is a checklist of what ETFs are and what they most certainly are not:

Definition

They are…representative of an asset class: Most ETFs do exactly what they say. They own groups of stocks, such as dividend-paying U.S. blue chips, then offer you access to that group through a single, tradable, liquid share.

They are not…foolproof: One of the drawbacks of niche ETFs is “tracking error,” the tendency to not return exactly what the underlying assets might have returned. The more exotic an ETF, the more likely there are tracking errors. An ETF meant to approximate the daily price of oil, for instance, might be off by a wide margin if followed day-to-day. The fund cannot literally buy and sell oil, so it has to approximate the trade using complex financial instruments. Thus the errors.

Taxes

They are…tax-efficient: Building a stock portfolio by hand can cost you. If a given position performs well over a few months, you might feel the need to sell it, triggering the short-term capital gains tax. ETFs handle large amounts of shares on behalf of big banks and hedge funds. The result is that ETFs can give small-time fundholders access to shares without having to buy and sell.

They are not…tax-free: Unless you hold them in an IRA, 401(k) or Roth IRA, your gains from buying and selling an ETF get the same tax treatment as any other taxable investment. Ditto any dividends you receive.

Cost

They are…cheap: Since you are buying into a pile of stocks already held by a large fund company, and since the fund company isn’t doing much work to maintain it, the costs can be incredibly low. Some of the cheapest broad-market funds are well below 0.10%, even down to 0.05%, and some companies allow you to trade the broad-market ETFs at no cost. In comparison, mutual funds routinely sold via company 401(k) plans average 2% when you add up the various fees.

They are not…costless: Fees are ongoing. It’s charged against your account every year for as long as you invest (usually by subtracting a bit of your dividend payout). If you want to buy a big position in a company and plan never to sell, your cost is a one-time trading fee of under $10 and that’s it. You keep 100% of the dividends and often can reinvest dividends automatically at zero cost through your financial brokerage or the company itself, using what is known as a DRIP plan.

Ability to Trade

They are…liquid and easy to trade: Money managers love ETFs, since they offer an easy-in, easy-out to entire markets at the drop of a hat. Smaller investors love them because they can, if you like, buy a single share and effectively own 1,000 companies or more.

They are not…a perfect trading tool: A lot of small investors, and large ones, are doing just that, buying ETFs in order to speculate on short-term noise in the market. Most of them end up sorrier for the experience. “The most actively traded stock today, every day, is the SPDR, the Standard and Poor’s 500 exchanged-traded fund,” Vanguard Founder Jack Bogle told Morningstar in a recent interview. “And it turns over at about 10,000 percent a year. Ten thousand percent a year, and I think 25 percent is a high turnover!”

Position in Your Portfolio

They are…a good way to build a portfolio: Just about the best way to use ETFs is to first create a reasonable asset allocation and then buy broad, low-cost ETFs to approximate the assets you need. Then rebalance it periodically. It’s a low-cost way to build wealth.

They are not…a replacement for intelligence or responsibility: Too often, as Bogle points out, investors use ETFs to play a hunch, then bail out when the idea goes sour in a few weeks or months. Using ETFs to speculate is still speculating, no way around it.